Efficient Market Hypothesis
Efficient Markets
In an efficient stock market, the price for any given stock effectively represents the expected net present value of all future profits Interplay of supply and demand sets prices
Price for any stock or bond represents collective wisdom about future prospects
Efficient Markets Hypothesis
EMH holds that security prices fully reflect all available information at any time.
Individual and professional investors buy and sell stocks under assumption that intrinsic value differs from market price. Perfectly competitive securities market:
New information arrives at market independently and
randomly. Both buyers and sellers adjust rapidly to new info. Current security prices reflect all relevant risk/return info.
Reaction of Stock Market to New Information
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Random Walk Theory
Random Walk: irregular pattern of numbers that defies prediction Random Walk Theory: concept that stock price movements do not follow any pattern or trend Fair Game: even bet; 50-50 chance Random Walk With Drift: slight upward bias to inherently unpredictable daily stock prices
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Random Walk Research
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Evidence supports notion of random walk
Levels of Market Efficiency
Weak-Form Hypothesis
Semistrong-Form Hypothesis
Strong-Form Hypothesis
Weak-Form Hypothesis
current prices reflect all stock market information; trading rules based on past stock market return or volume are futile. If a market is weak form efficient, then technical analysis should not be effective in picking stock for above average profits.
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Tests of Weak Form Efficiency autocorrelation tests filter rule tests run test
An
autocorrelation tests investigates whether security returns are related through time. A runs test, for example, measures the likelihood that a series of two variables is a random occurrence. A filter rule is a trading rule regarding the actions to be taken when shares rise or fall in value by x%. Filter rules should not work if markets are weak form efficient.
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Semistrong-Form Hypothesis
The
semi-strong form says that prices fully reflect all publicly available information and expectations about the future. This suggests that prices adjust very rapidly to new information, and that old information cannot be used to earn superior returns.
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Studies of Semi Strong Form Efficiency
Event study
Portfolio study
Event
Study
Examines the market reactions to and the excess market returns around a specific information event like acquisition announcement or stock split.
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Portfolio study Characteristic (low price earnings ratio or whatever) is created and tracked over time see whether it earns superior riskadjusted returns.
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Strong Form
The strong form says that prices fully reflect all information, whether publicly available or not. Even the knowledge of material, nonpublic information cannot be used to earn superior results. Most studies have found that the markets are not efficient in this sense.
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Public vs. Private Information
Stock Market Information: stock price and trading volume figures
Public Information: freely shared information
Nonpublic Information: proprietary data
Insider Information: proprietary information within a firm
EMH & Fundamental Analysis
Fundamental Analysis seeks to determine a companys outlook based on factors related to the company itself
Fundamental analysis includes: Company Analysis
Evaluation of the business model Financial Statement Analysis
- Ratio Analysis Cash Flow Analysis Management Analysis
Economic Analysis
Economic Forecasts and Trends
Industry Analysis
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Failures of fundamental analysis
Financial data: variables are fundamental and directly relate to the company. Unscientific: Do not give the clear picture of company value. Long time frame: the analysis is made for the long period of time rather than a day or a week
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EMH & Technical Analysis
Tech Analysis: examining historical date on stock prices and trading volume to predict future prices
Chartist: practitioner of technical analysis
Almost all studies indicate that such focus on past trends is worthless
FAILURES OF TECHNICAL ANALYSIS
Data-Snooping Problem: reliance on chance observations in historical data as guide to investment decision making. Out-of-Sample Experiment: test of any historically useful technical trading rule over some new sample of data that was not used to derive that rule Back Testing: backward-looking analysis
FAILURES OF TECHNICAL ANALYSIS
Believing-is-Seeing Problem: Eager to believe
in the possibility of beating the market, investors sometimes see results that do not really exist.
There is no robust evidence that technical
trading rules can enhance investor or trader profits.
If markets are competitive and current prices fully reflect all information, then buying and selling securities in an attempt to outperform the market will effectively be a game of chance rather than skill!
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THANK YOU
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